Tuesday, April 02, 2013

I have been reading Manias, Panics and Crashes: A History of Financial Crises by Charles P. Kindleberger and Robert Z. Aliber. The book points out that in the last forty years there have been four waves of financial crises, each wave affecting several countries. These crises have been more frequent and wider in effect than in previous centuries. Indeed the authors suggest that these crises were related; money flows triggered by international currency flows following each crash leading to new bubbles which on implosion trigger another crisis.

The Bretton Woods system introduced after World War II was intended to prevent the kind of contagion that led to the Great Depression. Among other things the Bretton Woods conference led to the establishment of the International Monetary Fund, and established a system by which each country had a target for the value of its currency against either gold or the American dollar; each country would have to keep the actual value of its currency within narrow bounds around its target. Countries could only modify the target exchange rate with approval of the IMF; they could obtain funds from the IMF to deal with balance of payments deficits.

In the 1960s, Germany's and Japan's rebuilt economies were surging and the United States economy had dropped to 27% of the global GDP. The costs of the Vietnam War and increased domestic spending were increasing the U.S. inflation rate. There were balance of payments deficits and trade deficits, leading to a run on gold. In 1971, the Nixon administration took the United States off the gold standard. These events "helped end the existing Bretton Woods system of international financial exchange, ushering in the era of freely floating currencies that remains to the present day."

The United States experienced very high rates of inflation in the 1970, triggered by the oil shocks of the 1970s. The Federal Reserve under the leadership of Paul Volker raised interest rates in the United States which had averaged 11.2% in 1979, to a peak of 21.5% in 1981; the inflation was tamed, there was a recession; the dollar price of gold peaked within weeks of the announcement of this policy in 1979. The changes in the U.S. situation triggered a series of problems in Germany, Japan and Latin America.

How much of the new instability of global economics with shocks triggering shocks was due to the failure to replace the Bretton Woods system with something capable of dealing with the increasingly globalized world, and to the behavior of the United States government?